When Honduras inspired the term "banana republic" a century ago, the description, though pejorative, had a darkly comic connotation.

The central American republic still bears some resemblance to the corrupt plutocracy depicted by William Sydney Porter in his 1904 novel, Cabbages and Kings – but nobody is laughing now.

The horrific prison fire which killed 359 people last week – all of them inmates apart from one visiting wife – was just the latest sign that this once-sleepy country is enduring a crisis of state dysfunction, with tragic consequences. Last weekend, another blaze swept through three markets in Tegucigalpa, injuring 11 people and sending plumes of black smoke over the capital, symbolising for many a sense of events spiralling out of control. Then, on Monday, hundreds of relatives of the prisoners who suffocated or burned to death in the fire stormed a morgue to demand the remains. Police fired teargas to disperse them.

"The situation in Honduras is dire, arguably the most troubled in the region," said Michael Shifter, president of the Inter-American Dialogue thinktank. "The country presents a perfect storm: endemic poverty and notably fragile institutions buffeted by uncontrolled crime and aggravated by spillover from Mexico's drug war and a profound political crisis."

Honduras is the world's murder capital – with 85 homicides per 100,000 people, a rate 12 times the global average – amid the violent fallout from a 2009 coup. "You often hear gunshots at night, and people are very much aware of how dangerous the city is," said Jill Powis, a human rights worker in Tegucigalpa. "Many people point to the irony that they have become the prisoners while, because of the failures in the justice system, the criminals roam free. You very much notice it in the city centre at night, which is now dead."

Most killings happen in urban slums which even by Latin American standards are shocking: mounds of fly-blown rubbish, potholes with fetid water, child glue-sniffers with red noses and glazed eyes. Armed youth gangs known as maras, originally formed in southern California, fight each other for turf and extort a "war tax" on buses, taxis, shops and other businesses, killing late payers to intimidate others.

Mexican drug cartels, which offload cocaine-filled planes in rural areas, compound the violence with their own battles for routes and influence. With 98% of murders reportedly going unpunished, life, and the taking of it, appears cheap. Police officers moonlight as hired killers. More than 20 officers were allegedly involved in killing a university rector's son but all walked free.

Poverty drives much of the violence, said Trinidad Sanchez, a former head of Comal, a farmer-run group which promotes fair trade. "The lack of education and employment, not having enough clothes, being hungry, it creates huge stress." His nephew, Johnny, 25, a taxi driver accused of theft, died in the jail fire. "Every time I visited I saw only peasants and indigenous people in the jail, never the wealthy."

Shockwaves from the overthrow of a leftwing president, Manuel Zelaya, in 2009, which pitted the middle class and elite against the president's supporters in the slums and countryside, still rumble. "That crisis brought in some dubious figures to the government," said Shifter. "Honduras's isolation from the international community for two years did not help matters. The withdrawal of outside support as a way to punish the acting government only opened the way to heightened criminal activity."

A provisional government gave way to the election of President Porfirio Lobo, who has gradually gained international legitimacy, but critics say US aid focuses on military and counter-narcotics initiatives, not jobs and poverty.

Many Hondurans feel abandoned by the state, said Sanchez. "Social advances went into reverse. Faith in institutions has degenerated." Honduras, he said, was ruled by a handful of US-educated families which dominated the economy, media companies and state institutions. "They think it's theirs to run, they have a complete sense of entitlement."

Sanchez was speaking from Chicago, having fled Honduras after police raids on his home and office, part of what activists call a campaign of harassment and intimidation against critics. Dozens of journalists and activists who promote land reform or gay rights, among other causes, have been gunned down, casting fear and self-censorship over public discourse.

"With a murder rate so high it's almost impossible to say what is a targeted killing and what was an incidental result of gang violence … but there exists a very real level of political violence," said Jamie Collinson, a British human rights activist who has worked in Honduras. "The state has been implicated in targeted disappearances and killings of members of resistance organisations working for social justice."

The government denies that, saying common crime is to blame, and that police reform is under way. The jail fire, however, has exposed the state's weakness. It was initially reported that an inmate with a grudge started the blaze, or maybe an electrical fault, but now authorities are investigating whether it was deliberately started, with guards' help, to aid an escape.

This week, as forensic teams tried to identify prisoners' remains and the first burials began, the only cheering news were tributes to Marcos Antonio Bonilla, an inmate known as Shorty, who was credited with saving hundreds of lives. He was outside the cells when the fire began and picked up a guard's dropped keys (others said he grabbed them) and opened padlocked doors. Without Bonilla Honduras would be mourning an even greater tragedy, one prisoner, Rosendo Sanchez, told reporters. "Shorty was the only one with honour."